Should Value Managers Buy Gold?

There has been a flurry of articles written about precious metals lately, not surprising considering the strong rally in the first half of 2016, which saw gold and silver outperform most mainstream asset classes by some margin.

Some of the articles have been wildly bullish, whilst others are unconvinced by the recent rally, believing that gold is still stuck in the cyclical bear market that can be traced back to the latter part of 2011, when gold peaked at around USD $1900oz.

One of the more interesting articles we’ve seen on the topic of late came from Montgomery Investment Management, run by Roger Montgomery, one of Australia’s most successful and best known value investors. They discussed the precious metal in an article titled; “Is it time to buy gold?”, which they published on June 28th, just before the end of the financial year.

It is an interesting question no doubt, but we want to ask it (“Is it time to buy gold?”) from a slightly different perspective, seeing whether or not it would make sense for value equity managers to buy gold in their portfolios.

Starting with the Montgomery article itself, and it does make a number of valid observations, noting that; “Central to the traditional idea of investing is the notion that the future cash flows generated by an asset provide a satisfactory return on the capital outlaid to acquire it.  It is these cash flows that give financial assets their value and allow an investor to estimate where price and value sit relative to one another.”

This is of course a problem for gold, the team at Montgomery correctly highlight, as it doesn’t get its value from cash flows, for there are none (on a technicality one could argue this is wrong for gold can be lent out for income, but for 99.9% of investors it is true).

Ergo, as Montgomery can’t value gold the way other financial assets can be, they “are left with the idea that gold is worth whatever people think it is worth at the time; an amount that tends to be higher in times of uncertainty, and lower in times of stability. But nowhere is there an ‘anchor’ to tell us whether the current level may be too high or too low. If you have the ability to predict changes to the future level of uncertainty, then gold may be something you can profit from.”

These observations are all accurate, but are also to some degree meaningless. After all, gold is a zero credit risk, highly liquid asset with an unparalleled history of wealth preservation over the long-term, and strong outperformance through various parts of the market cycle where financial assets are less rewarding.

Even a gold bear should acknowledge the above points, just like a gold bull should acknowledge that ownership of productive businesses is a better way to make money over the very long run, with gold the better store of wealth and risk off asset.

The point being – if you look at gold and simply say “nope – I can’t value it by traditional means, therefore its not an investment”, then you would by definition never own any gold at all, or invest even 1% of your portfolio in it. During the 1930’s when equities crashed 90% and gold held firm. Nope – can’t value it. During the 1970s when the real return on most financial assets was negative, but gold went up by a factor of 25. Nope – can’t value it. During the past 15 years when it has outperformed all liquid asset classes, despite the complete lack of official inflation. Nope – can’t value it.

I’m not sure such an approach, whilst technically correct, is a super useful way for the average investor to look at the metal, and the potential role it can play in a portfolio, especially when gold can be seen, as Montgomery acknowledged, as “an alternative store of wealth to other currencies”, including the Australian dollar presumably.

This is an important point, for the Montgomery Fund, which is apparently sitting on over 30% cash at this very time (as are many benchmark unconstrained value managers), explained the reasons underpinning this allocation, noting on June 27th (the day before the gold article) that cash itself can be king when the market holds the aces. Quite correctly in our opinion, the team there noted that investors should not_; “eschew the wealth-protecting and wealth-building power of cash either.”_

This article, which is well worth the read as well, correctly points out that whilst stocks are the better long term wealth builder, one needs to be careful from being fully invested at all times, especially when markets are expensive.

As the article states; “Stan Druckenmiller recently highlighted 1981 as a beautiful time to be invested in equities. Interest rates were at 15 per cent and the real rate was 5 per cent. Those high rates ensured companies were careful with their capital allocation and interest rates were about to commence a long decline. Productivity received a boost from the advent of the internet and debt was so low that a long-run credit-fuelled expansion was possible. The S&P500 Price to Earnings ratio was just 7X. Between 1981 and 2000, the S&P500 produced a return of almost 15 per cent per annum, creating a 16-fold increase of your wealth.

Today, we have almost the mirror opposite image. Debt is double that of 1981 and appears to have reached its limit. Full employment and declining productivity suggests corporate profit margins are about to decline and interest rates cannot fall much further, and may begin to rise.  Since 2011, earnings per share in aggregate have not grown but US company payout ratios have increased from 55 per cent to more than 75 per cent. Combined with elevated levels of debt, it suggests little earnings growth will be experienced in the near future. And investors are paying 18x earnings. So how can the polar opposite of 1981, be an equally attractive time to invest? It cannot.

The relative unattractiveness of the equity market as whole, plus the myriad of unresolved risks that the global economy has to deal with, are factors we couldn't agree with more, and to that end, we think the team at Montgomery are absolutely right IMO to point out that cash, despite being a terrible long term investment; “should be thought of as a call option over future cheap shares with no strike price and no expiration. Cash is guaranteed to avoid one risk – the risk of permanent capital loss – but it is also guaranteed to adopt another risk – the loss of purchasing power.”

All of the above is true, and they are important observations for investors to consider when putting together their portfolio. But there are a few comments/questions worth asking here.
The first is, whilst we agree that paying 18x times earnings for stocks is risky (indeed investors are paying circa 25x cyclically adjusted earnings in the US right now), how does one “know” that this is too expensive, and that investors are likely too optimistic right now? The only way is by looking at history as a guide, though this is not of course any guarantee as to what will transpire in the months and years ahead.

In short, if you are expecting that in the future investors will not be willing to pay the kind of multiple for earnings that they are today, then to one degree or another you are clearly predicting changes to the future level of uncertainty. If you can do that for stocks, why can’t you do that for gold, or bonds, or any asset class for that matter?
Another question worth asking is, what form of cash to hold as a defensive asset?

After all, if stocks are expensive, which justifies a cash position rather than being fully invested, does it have to be Australian dollars? Why not hold gold as your cash buffer, or a combination of gold and Australian dollars, when gold is a monetary asset as well?

Crazy talk some might say, considering gold is in and of itself a volatile asset in the short term, and pays no income. But is it that crazy, when one considers the lack of income one earns on cash today, the uncorrelated nature of gold relative to equities, and the fact that gold will (over the long run at least), be far less likely to reduce purchasing power, compared to money in the bank.

To consider this in more detail, we ran a scenario analysis looking at three portfolios, from 2001 inclusive to the end of March 2016.

Our portfolios were constructed as follows:

• 70% in equities and 30% in cash

• 70% in equities and 30% in gold

• 70% in equities and 15% in both gold and cash (call it a hybrid money model)

Note there was no particular reason to choose 30% as the cash weighting, it just aligned with the number that we saw reported in a recent article which stated Montgomery’s cash position was near this level, though the latest factsheet we found for the fund (April 2016), reported that cash was closer to just 23% of fund assets.

The results, which you can see in table form below, are pretty interesting we think.    

Source: ABC Bullion, Global Financial Data

A few things stand out when looking at the above data:

• The average return on gold is substantially higher than the average return on cash in months when equities decline, whilst the average decline in gold during rising equity markets is quite small

• A portfolio with 30% gold would outperform the stock market by over 1.6% in declining months for equities, and also outperform the fund with 30% cash by over 50bps

• A portfolio with 30% gold instead of 30% cash would be more volatile in negative months for equities, but still substantially less volatile than equities themselves

• A hybrid model of Australian dollars and gold would not only have lower volatility than a pure equity and cash model, but also exhibit substantially higher returns, outperforming the latter by circa 30bps in months when equities decline

It is also worth pointing out that whilst cash has averaged a return of circa 40 bps in the rising and falling months over the past 15 plus years, that number has of course now fallen below 20bps as of now, with the return on cash just as if not more likely to decline than rise in the months and years ahead.

From the above data, it would appear that gold can indeed play an important role as a defensive cash like asset for risk conscious equity managers. It can add some upside to portfolio returns in risk off markets without any noticeable increase in portfolio volatility, though whether or not this continues in the months and years ahead of course remains to be seen. We are all in unchartered waters here, and are forced to place our bets one way or the other.

As a final comment, Druckenmiller, the legendary manager of Duquesne Capital, and the man the team from Montgomery quoted in their article on cash, would appear to be in full agreement with them on the risks in financial markets right now, and the necessity of holding money in a portfolio today.
Turns out the largest position in his portfolio right now is gold!

Until next time,

Jordan Eliseo

Chief Economist
ABC Bullion

Disclaimer

This publication is for educational purposes only and should not be considered either general or personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, and past performance is not necessarily indicative of future performance. Any prices, quotes, or statistics included have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness.